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Bankruptcy and S Corporation Pass-Through

A
lthough there are some signs the economy is improving, many businesses
continue to fail. Recently the Tax Court considered the effect of an S
corporation’s selling an asset while in bankruptcy. All S corporation
shareholders contemplating filing for corporate bankruptcy need to
consider the potential tax outcome of such a move.

Alphonse Mourad was the sole shareholder of V&M Management Inc.,
an S corporation. On January 8, 1996, the corporation filed a Chapter
11 bankruptcy reorganization petition. The court appointed an
independent trustee to administer the reorganization. On September 26,
1997, the court approved the plan. The trustee sold the corporation’s
main asset for $2,872,351, realizing a gain of $2,088,554. The trustee
reported the gain on form 1120S and sent a form K-1 to the
shareholder. Mourad did not report the gain as income and the IRS
determined a deficiency. He later claimed he should not be treated as
the shareholder of an S corporation following V&M’s bankruptcy
petition. Mourad also argued he should not have to report the gain
because he did not benefit from the sale.

Result. For the IRS. The general rule is that
following a valid S election, shareholders must report and pay tax on
the corporation’s income. This system of taxation continues until the
S election terminates. A company’s S corporation status can end in any
of three ways:

Shareholders voluntarily revoke the entity’s S
corporation status. The corporation has excessive passive income for three
consecutive years. The corporation ceases to be a small business corporation
that is eligible for S status.

The first two circumstances did not apply to this case. Therefore,
the court addressed whether the corporation had stopped being eligible
for S status.

To be eligible for S corporation status, a corporation cannot have

More than 75 shareholders. A shareholder that is other than an individual, estate or
qualified trust. A nonresident alien shareholder. More than one class of stock outstanding.

Filing a bankruptcy petition—as V&M Management did—did not
violate any of the above requirements. Therefore, according to the
court, the company’s S election was not terminated.

As additional support, the court referred to a prior case, In re
Stadler Associates Inc., in which the Florida bankruptcy court
held that filing a bankruptcy petition did not terminate an S
election. Although Stadler involved a Chapter 7 bankruptcy
and Mourad Chapter 11, the result was the same. The
differences between the two filings were in the remedies the companies
sought, not the tax treatment. The court ruled that V&M’s S
corporation status was still in effect and that Mourad should have
included his share of the gain in income.

In rejecting Mourad’s contention that he shouldn’t be taxed on the
gain because he didn’t benefit from the property’s sale, the court
noted that the taxpayer previously had benefited from the single
taxation of the company’s income and the pass-through of losses.
Therefore, he now had to pay tax on the pass-through gain from the
sale of the entity’s property, even though the taxation would be
detrimental to him. The result, according to the court, would be
equitable.

There was one concern the case did not raise, and therefore, the
court did not deal with it. Since the corporation filed a bankruptcy
reorganization plan, it likely was insolvent. In that case it could be
argued the creditors were the de facto shareholders and should have
reported the gain. However, it isn’t likely any court would have
accepted this argument and shifted the tax to the creditors. As a
result all S shareholders should be prepared to report and pay tax on
any gains from asset sales during a bankruptcy reorganization.